The United States has suffered a bitter blow in a long-running trade dispute with the European Union, and could now face sanctions worth more than $4bn.

The World Trade Organisation (WTO) found that massive tax breaks for firms like GE, Boeing and Microsoft amounted to illegal export subsidies.

It was the fourth time in five years that the WTO ruled the tax breaks illegal, and has now paved the way for the EU to impose punitive tariffs on imports from the US.

This is just the latest in a host of transatlantic trade disputes. In previous quarrels - over beef and bananas - the WTO had found in favour of the United States, resulting in sanctions on EU exports.

Mutual damage

The United States has already offered some concessions in the dispute, but the WTO panel found that Washington "failed fully to implement the recommendations and rulings" made by the trade body.

Robert Zoellick, the US Trade Representative, said the White House was "disappointed" with the outcome.

He said the US government intended to "seek to cooperate with the EU in order to manage and resolve this dispute".

But he insisted that the US had been right all along.

"We knew it would be an uphill struggle," he said, "but we believed it was important to make our case for a level playing field on tax rules."

Any trade war is likely to hit the economies of both sides - with the United States already in the throes of a recession and the European Union suffering a sharp economic slowdown.

Kimberly Pinter of the National Association of Manufacturers in the US said "they [the EU] don't want to sanction us any more than we want to be sanctioned".

Any sanctions "would hurt them as much as it would hurt us".

Clyde Prestowitz, a former US trade negotiator, said the "timing for the Europeans to do something very Draconian isn't very good."

Horse trading

EU officials acknowledge that this could be true.

So the EU has stressed that retaliation is not its preferred option.

Instead, some sort of 'horse-trading' is expected to take place, said observers.

But the EU expects Washington to make the first move.

EU Trade Commissioner Pascal Lamy said it was now "up to the US to comply with the WTO's finding to settle this matter once and for all. As to how, we look
forward to rapid US proposals."

Arbitration

The next step in the dispute is the creation of a WTO arbitration panel.

The panel will decide on the amount of sanctions to be imposed on imports from the US. It has 60 days to do the job - from the day the WTO officially adopts the ruling, expected to happen later this month.

In deciding on an amount, the WTO would aim to reflect the damage caused to European firms by the tax breaks in the US.

Once an amount is approved by the WTO, the EU could impose the sanctions right away.

Possible solutions

To avoid sanctions, the US would have to either:

change the current tax legislation

compensate the EU by slashing tariffs or take other actions to enable the EU to export more to the US

persuade the EU to delay imposing sanctions and deal with the issue as a part of the next round of WTO trade talks which are due to start this year, and are expected to last until 2005.

The first option is unlikely: The US would be hard-pressed to push through a new tax reform legislation package in time, given that the arbitration panel's final decision is due around Easter.

And with the US recession still showing no sign of easing, the US is increasing its tariff barriers on many products, such as steel, rather than cutting them.

Instead, the US may threaten counter-retaliation.

Different tax breaks

The EU may be amenable to some form of compromise, however, since the US is expected to argue that Europe also uses export tax breaks, and that its whole corporate tax structure is unfair to US companies.

Indeed, the WTO panel did itself query whether some EU tax regimes comply with its rules.

Also, the EU has lost other trade disputes with the US recently and could use this latest one to regain lost ground in other areas.

Although the two trade blocs reached agreement on a long-running dispute over imports of bananas from the Caribbean, there are still conflicts over the import of US hormone-treated beef and genetically-modified foods.

Long-running conflict

The current conflict arose in 1997 when the EU began objecting to US tax breaks for exporters.

The tax breaks put the exporters at an advantage when competing with European firms, the EU argued.

The WTO agreed in four rulings, but the US appealed on each occasion, while at the same time moving part of the way towards compliance by extending the tax breaks to foreign companies based in the US.

The EU dismissed this as "window dressing," and said the new tax regimes introduced were as bad as the old ones.

In the end, in November 2000, the EU asked the WTO for permission to retaliate.